William Seidman, Inventor of Tranched, Credit-Rated Securitization and Former Head of RTC: “Self-Regulation, Unsupervised, Does Not Work”

Monday evening while running some errands, I listened to a portion of Mark Thompson’s radio show on Sirius Left, with Thom Hartmann as guest. Hartmann provided the best description that I have heard to date of how the financial system has collapsed and the ongoing risk that further collapse is likely.

Hartmann played several excerpts of the audio from a series of YouTubes of comments delivered by L. William Seidman on October 9, 2008 at Grand Valley State University in Michigan. Seidman is a former head of the FDIC and was head of the Resolution Trust Company, which was formed by the government to dispose of toxic debt during the Savings and Loan Crisis in the late 1980’s and early 1990’s. The YouTube below is the first part of his remarks and is number two in a series of seven YouTubes (number one is just the university president killing time until Seidman made it to the stage). The good information starts at about five minutes into the video, when he starts to explain tranched, credit-rated securitization, which he says he invented while running the RTC:


Here is an another explanation of tranches and their role in securtization from the Washington Post:

CDOs were first sold in the 1980s, part of a revolution in corporate finance called "securitization" that fueled the unprecedented boom in available credit. Lenders could package their mortgages, credit card loans, equipment leases, even corporate debt, and sell securities backed by the interest payments. This maneuver transferred the risk of not getting paid to the investors who bought the securities. The deals returned cash to lenders, which they could plow into new loans. This efficient machine pushed borrowing rates lower, creating a win-win-win for consumers, lenders and investors.

Wall Street saw any income stream as a candidate for securitizing. Mortgages went into pools that became the basis for mortgage-backed securities. Ditto credit cards and other forms of debt. The list was long. All those securities were scooped up and used as collateral for CDOs. Indeed, this diversity of loans was thought to be a plus for the CDOs’ safety.

The entire chain depended on the concept of layered risk. Once the ratings firms evaluated the quality of the securities, a ladder would form: The securities on the top rung, or "tranche," were considered low risk and won a AAA rating. In return for their safety, these bonds paid the lowest interest rate. The reverse was true at the other end: The lower tranches absorbed the first losses from loan defaults, buffering the securities in the higher tranches. This extra risk earned them lower ratings, often AA, BBB or lower, but paid the highest interest rate.

The computer modelers gushed about the tranches. The layers spread out the risk. Only a catastrophic failure would bring the structure crashing down, and the models said that wouldn’t happen.

An incredibly important point that Hartmann didn’t mention comes at the very end of this YouTube. After describing the investment vehicles he developed at RTC, Seidman says that while at RTC, he always "retained that last piece". He did this, he said, because that meant that he had "an interest in seeing that this all worked", because he was the "last one on the ladder" and got paid last.

Moving to the second YouTube (number three in the series of seven), Seidman goes on to explain the massive growth of securitized debt and the derivatives that were subsequently developed to further leverage them. A key moment occurs at 3:20, where he says "If an industry needs regulating, self-regulation, unsupervised, does not work."

The lack of regulation he was referring to related, in large part, to the selling off of all layers of the tranches, so that the party originating the investment vehicle no longer had an interest in structuring it so that the debt eventually got paid. Then, with multiple new layers of derivative vehicles piling on top of these very risky instruments, Seidman described how the situation was made even worse.

At around 6:30 of this video, Seidman gets to the key issue of vehicles known as credit swaps, also called credit default swaps or CDS. He tells us that Alan Greenspan rejected the idea of regulating credit swaps because the buyer and the seller are so sophisticated that a regulator could add nothing to the transaction. This refusal by Greenspan, in my opinion, is the single biggest mistake made on the long road that took us to the current fiasco.

Seidman explains that in AIG alone, a separate department of 400 people did nothing but write credit swap contracts. He says they wrote "trillions" in these contracts. Hartmann said that there was a recent disclosure (which I couldn’t find, a link would be appreciated on this point) that AIG wrote about $15 trillion in credit swaps.

That number deserves some context, and this is where Hartmann did such a good job of describing the magnitude of the problem. The US GDP (see page 7 of the link) is $14 trillion. So AIG, by itself, wrote enough credit swap contracts to equal the entire GDP of the United States.

But it gets worse. Here is Mike Whitney, at Counterpunch, quoting Bill Gross:

According to the Bank for International Settlements (BIS), CDS totaling $43 trillion were outstanding at year end 2007, more than half the size of the entire asset base of the global banking system. Total derivatives amount to over $500 trillion, many of them finding their way onto the balance sheets of SIVs, CDOs and other conduits of their ilk comprising the Frankensteinian levered body of shadow banks.

That is just staggering: there are derivatives in the market issued for over $500 trillion. The total global GDP is only about $70 trillion. The entire world economy is not capable of paying off these instruments.

The world financial markets have demonstrated to us what happens when greed is allowed to run unchecked. In trying to grab an ever bigger piece of the pie, they have caused the pie to cease to exist.

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